Why Trying To Beat The Market Is Foolish But Indexing Might Also Be

Proponents of indexing as the best investment strategy seemed to take great delight in reporting how the vast majority of professionally managed portfolios (mutual funds, separately managed accounts, hedge funds, ETFs, etc.) fail to outperform the S&P 500. Therefore, they argue, it is best not to even try to beat the market. Investors should simply invest in index funds and forget about it.

At first glance, this would appear logical because in truth their statistics are true and valid. On a total return basis, the vast majority of investor funds that are professionally managed do in fact underperform the S&P 500 on a total return basis. However, with this article I intend to illustrate that there is a significant flaw with this line of reasoning.

Prominent Reasons Why Active Management Often Fails to Outperform

However, before I delve too deeply into discussing the great flaw, I would like to comment briefly on a few extenuating reasons why many actively managed accounts might underperform. For brevity’s sake, I am not going to try to list all the extenuating circumstances, for that would be the thesis for a separate article. In other words, a comprehensive discussion would be too extensive, and not the true focus of what I intend to offer with this article.

Some of the most prominent reasons for failure to outperform are management fees and costs, over-diversification, restrictions imposed by investment policy statements, and perhaps the biggest factor -being victims of their own success. The first couple of reasons are self-explanatory, therefore, I will limit my focus to the last reason I presented.

For example, a small and newly created mutual fund might put together an extraordinary track record over its first few years of existence. This extraordinary record could be a function of both its small size, and perhaps the fact that it was created during an attractive market environment. In other words, it was created at a time when stock valuations (prices) were low.

However, assuming they do in fact create a great record, that will often attract significant amounts of new money. But it is quite possible, and perhaps even quite common, that their greatest inflows will come during a time when the market environment has become unfavorable. In other words, they get a bucket load of money at precisely a time when it’s difficult for them to invest it at attractive valuations. However, invest it they must. Consequently, future performance will suffer as a result.

In contrast, if a mutual fund produces a poor track record over a certain period of time, it will often suffer extensive liquidations. These liquidations are then theoretically occurring at precisely a time when their better judgment would suggest buying stocks over selling them. In other words, they are forced to sell undervalued selections instead of the more prudent strategy of buying or at least holding on. I could go on, but I hope the reader gets the point. Active managers face numerous extenuating circumstances that the “market” is spared.

I want to be clear that I am not attempting to justify underperformance. Instead, I am simply attempting to illustrate a few prominent reasons why it happens. Moreover, what follows will deal with what I consider to be a more important concept which I will frame in the form of a question. Should investors even concern themselves with trying to outperform the general market on a total return basis? My answer is emphatically no, and my reasons represent the main thesis behind this article.

Beat The Market: Basing Portfolio Design on Need

I did not title this article as I did to be provocative. Instead, I believe the title puts a spotlight on the importance of how I believe portfolios should be properly designed and constructed. Rather than worrying about beating the market, I believe that portfolios should be designed based on the individual investor’s specific goals, objectives and risk tolerances.

With that said, I am also suggesting that an S&P 500 (.INX) index fund may be a completely inappropriate investment choice for certain investors. There are numerous reasons why I believe this to be true. However, my primary reason is because the S&P 500 index may fail to meet a specific investor’s goals, objectives and risk tolerances on many fronts. I will elaborate more on this important point later in the article. But first, allow me to present a 20-year earnings and price correlated F.A.S.T. Graphs™ of the S&P 500 index with performance to establish a benchmark that I will later utilize to support my thesis.

I chose the following 20 calendar year Earnings and Price Correlated graph of the S&P 500 for several reasons. First of all, the 20-year graph represents the full extent of the data available. Second, it also represents a starting period when the S&P 500 was reasonably within a range of its earnings justified fair valuation. Therefore, as I will show in a moment, long-term performance will closely correlate with earnings growth as price follows earnings over the long run. Moreover, the graph also vividly reveals periods in time when the S&P 500 became overvalued with price deviating from the orange line. But regardless of the timeframe I used, the most important metric I want to establish is the S&P 500’s current dividend yield of 1.8% (red circle). This will be a focal point of this article as I proceed.

For those sticklers for detail, I also include the following graph plotting the historical year-end P/E ratio of the S&P 500 over this 20 calendar year timeframe. Note that the beginning P/E ratio of the S&P 500 was 17.6. This would indicate that it was in fact modestly overvalued based on my fair value calculation of a P/E of 15. In other words, the S&P 500 was, based on my standards, moderately overvalued at the beginning of 1994, but only modestly so. In other words, the S&P 500 was not overvalued enough to invalidate my thesis.

The following 20 calendar year performance over this timeframe is presented below (Note: The precise dates of this performance measurement are from December 31, 1993 to the S&P 500’s close on October 16, 2013). Furthermore, the following performance report separates total return into its two components. The capital appreciation component of 6.7% per annum correlates closely to the 7.1% earnings growth rate, adjusted for the modest premium valuation mentioned above.

But the most important metric, and the second component of total return, that I would like the reader to focus on is the dividend income stream that the S&P 500 produced. Not only will this represent an income benchmark, it also simultaneously illustrates why I contend that the S&P 500 may not be an appropriate choice for certain types of investors. (Clue, the S&P 500 with a current yield of only 1.8% would not cover the income needs of retired clients in need of a minimum income provided from a yield of 3% or better).

However, not providing enough current yield may not be the only reason that an S&P 500 index fund may be inappropriate for retirees in need of income. There are also the issues of inappropriate levels of risk, as well as several specific constituents in the S&P 500 that retirees should never